DJIA ends week at record high but Nasdaq declines

I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said. – Alan Greenspan, American economist who served as Chairman of the Federal Reserve from 1987 to 2006

The stock market finally ended its string of losing Fridays with a gain as the Dow Jones Industrial Average closed at a record high while broad-market indexes finished the week slightly lower. Investors continued to gravitate toward the large, more stable, blue chip stocks that are perceived as being less risky and have lower valuations. These types of stocks are exactly those that comprise the DJIA index of thirty companies. The rotation into these stocks has come at the expense of certain technology, Internet, social media and biotechnology stocks as well as small cap stocks in general, which have tumbled over 8% since peaking over two months ago. Many of these stocks were overvalued based on their projected earnings growth and were trading on hope and dreams rather than traditional valuation metrics. While the drop in small cap stocks may signal trouble ahead for the broad market, it also could be viewed as a healthy sign that investors are focusing on valuation, price earnings ratios and dividend yields in their investment decision-making process. The decline in Treasury yields may also be cause for concern for the stock market as it suggests that the economy may be weaker than expected. The 10-year Treasury yield is now 2.60% compared to 3.00% at year-end and much lower than most economists forecast at the beginning of the year. But low yields and interest rates could also serve to stimulate the economy and actually be favorable for stocks. It’s these confusing and conflicting signals that are confounding investors and probably the reason the S&P 500 Index has remained virtually flat for the year. 

Last Week

While manufacturing data continue to improve, the service sector also has begun to expand more rapidly. The Institute for Supply Management (ISM) Index rose to its highest level in six months in April. The U.S. trade deficit also narrowed in its most recent report due to strong exports. Jobless claims for the week fell by 26,000, another positive sign that the labor market is getting stronger. In her congressional testimony this past week, Fed Chair Janet Yellen was optimistic about the economy and dismissed talk of a broad stock market bubble.

In overseas news, the European Union (EU) predicted gradual economic recovery through 2015 while European Central Bank President Mario Draghi hinted that the bank would likely lower interest rates at its next meeting. While Russian President Vladimir Putin offered some conciliatory remarks, pro-Russian separatists in eastern Ukraine vowed to proceed with a vote to secede from the country.

For the week, the Dow Jones Industrial Average rose 0.4% to close at 16,583 while the S&P 500 Index shed 0.1% to close at 1,878. The Nasdaq Composite Index declined 1.3% to close at 4,071.

This Week

There are a number of economic reports due out this week, including April retail sales, which are expected to increase 0.4%, much better than the previous month. Both the producer price index (PPI) and the consumer price index (CPI) are expected to show only modest increases in inflation. April housing starts should be fairly strong and signal an improving housing market while the May Michigan consumer sentiment index should show that consumers remain confident and optimistic about the economy.

Retailers will dominate the earnings releases this week as Macys, Wal Mart Stores, Nordstrom, Kohl’s and J.C. Penney all report their quarterly numbers. Cisco Systems and Applied Materials in the technology sector and John Deere in the capital goods sector also report earnings.

Portfolio Strategy

While the economy and the markets are both sending out mixed signals about their future direction, there are a number of reasons to be sanguine about the outlook for the U.S. economy. Despite all of its flaws, the April jobs report of 288,000 new jobs was encouraging and a hopeful sign for the labor market. Consumer sentiment also continues to be upbeat and consumer spending in March showed the biggest increase since August 2009. Durable goods orders at the end of April rose almost 3% and recent manufacturing data have confirmed continued growth and expansion. Corporate merger and acquisition activity has also been strong as deals have topped $1 trillion in 2014. Business spending is likely to increase, too, as a majority of businesses say that they will increase capital spending in the next year. Finally, the Federal Reserve remains confident about economic prospects as it continues to wind down the monthly stimulus program and believes that interest rates will remain low for a considerable time. With so much positive news, it is understandable why the economy and the markets should be viewed as a glass that is half full rather than half empty.